Litwin et. al. vs. Allen 1940Shientag, J.Digest by Clark Uytico

Topic: Duties of Directors and Controlling Stockholders

Summary:The directors of a Trust Company bought securities issued by Missouri Pacific Rail from Alleghany with an option to repurchase granted to the seller, Alleghany, at the same price it was bought by the Trust Company. Hence if the market price of the securities should rise, the holder of the repurchase option would exercise it in order to recover his securities from the bank at the lower price at which he sold them to the bank. If the market price should fall, the seller holding the option will not exercise it and the bank will sustain the loss. Thus, any benefits of a sharp rise in the price of the securities is assured the seller and any risk of heavy loss is in evitable assumed by the bank. The court here held that the act was not only ultra vires, but also inimical to the banking system, hence the directors are liable.

FACTSDerivative stockholders action brought on behalf of persons owning 36 shares of the stocks of Guaranty Trust Company (BANK for brevity). The defendants are the directors of the Guaranty Trust Company of New York. There are 4 transactions involved, but the most significant one is the Missouri Pacific Bond transaction.

This transaction involves the purchase by the bank (Trust Company or Guaranty Company or both) of Missouri Pacific Convertible debentures, to the extent of 3 million dollars, on October 15, 1930, through the J.P. Morgan and Co. firm, at par, from Alleghany Corporation, with the option of repurchase by the seller, Alleghany, within a period of six months.

Alleghany needed money for its purchase of certain terminal properties in Kansas City and St. Joseph, Missouri. Because of the borrowing limit in Alleghanys charter, which limitation it had already exceeded, Alleghany was unable to borrow money. To overcome this borrowing dilemma, and solely to enable Alleghany to consummate the purchase of the terminal properties, it sold some of the securities it held among which is a large block of about $23,500,000 Missouri Pacific convertible 5-1/2% debentures. These were unsecured and subordinate to other Missouri Pacific bond issues, but however, they were convertible into common stock at the rate of ten shares for each $1000 bond. The only purpose of this option was to make the transaction conform as closely as possible to a loan without the usual incidents of a loan transaction.

Before the Trust Company made its written commitment to J.P. Morgan to participate in the bond purchase, Guaranty Company (subsidiary of the Trust Company), committed itself to the Trust Company to take up the bonds from the Trust Company at the end of the six-month period, for the same price that the Trust Company paid.

During that time (1930), it must be remembered that the US has just suffered from the Great Depression of 1929 (aka the October 1929 Wall Street Crash). The financial conditions of the US were unstable and so, the prices of the bonds fluctuated. The decline continued and Alleghany was unable to purchase back the bonds, prompting the Guaranty Company to purchase the same from the Trust Company (the price had dropped to 98-5/8 of the original price).

Because of this, the stockholders involved commenced this suit against the directions, claiming a loss of approximately $2,250,000 in this transaction alone.

ISSUE1. WON the transaction was a loan.2. WON the directors are liable for committing an act (repurchase option) contrary to banking policy, and hence, ultra vires.

HELD1. NO. It was NOT a loan.2. YES. They are liable.

Dispositive: Settle interlocutory judgment in accordance with the foreclosing decision.

RATIO1. The transaction was not a loan:If the transaction was a subterfuge for a loan, then it was improper because the essential and most elementary requirement of a loan is lacking: no one obligated himself to pay it. The transaction was NOT a subterfuge for a loan; it was a substitute for a loan, and should be viewed on that basis. The fact that a transaction, from the point of view of the party receiving the funds, answers substantially all the requirements of a loan, does not make it a loan in law.

2. The option agreement is contrary to public policy and sound banking system:While there is no case precisely in point, if it is against public policy for a bank, anxious to dispose of some of its securities, to agree to buy them back at the same price, then it is even more so where the bank purchases securities and gives the seller the option to buy them back at the same price, thereby incurring the entire risk of loss with no possibility of gain other than the interest derived from the securities during the period that the bank holds them.

Hence if the market price of the securities should rise, the holder of the repurchase option would exercise it in order to recover his securities from the bank at the lower price at which he sold them to the bank. If the market price should fall, the seller holding the option will not exercise it and the bank will sustain the loss. Thus, any benefits of a sharp rise in the price of the securities is assured the seller and any risk of heavy loss is in evitable assumed by the bank.

While a resale option would force a bank to freeze an amount of cash equal to the selling price of the securities sold by it, a repurchase option would force a bank to freeze the securities themselves for the period of the option. In both cases, there is a contingent liability that the balance sheet does not show.

The act was Ultra Vires:The defendants however argue that the Trust company is wholly relieved of any risk of loss because it received a commitment from its wholly owned subsidiary whereby the latter undertook to take up the bonds from the Trust Company at the price paid for them in the event that Alleghany Corporation failed to exercise its option by the end of six months. However, to say that the option arrangement would be ultra vires as to the Bank, but that the taint of illegality would be removed if the Bank took an agreement from its wholly owned subsidiary to act as a receptacle of any possible loss, is contrary to law, to reason, and to every sense of justice.

The directors are LIABLE:The entire arrangement was so improvident, so risky, so unusual and unnecessary to be contrary to fundamental conceptions of prudent banking practice. Honesty alone does not suffice. There must be something more than honesty: there must be diligence, and that means care and prudence, as well. This transaction was unusual; it was unique, yet there is nothing in the record to indicate that the advice of counsel was sought. There is NO sound reason for a bank, desiring to make an investment, short term or otherwise, to buy securities under an arrangement whereby any appreciation will inure to the benefit of the seller and any loss will be borne by the bank.

The directors plainly failed in this instance to bestow the care which the situation demanded. Whichever way we look, this transaction was so improvident, so dangerous, so unusual and so contrary to ordinary prudent banking practice as to subject the directors who approved it to liability in a derivative stockholders action.

Directors liability is limited to the loss attributable to the improper repurchase option itself:The portion of the present transaction which is tainted with improvidence and negligence is the repurchase option itself. Once the option had expired, there was nothing to prevent the directors of the company, which had taken over the bonds in accordance with its agreement, from selling them. Any loss on the bonds which was incurred after the option had expired on April 16, 1931, was occasioned, as a result of the directors independent business judgment in holding them beyond the period. The further loss should not be laid at the door of the improper but already expired repurchase option.